(Part 2)

If there is one obstacle to the Fed’s hopes to slay inflation (and also to the desire for the US to weaken its own currency), it’s the obdurate American consumer. Helped by a robust labor market and a formidable supply of pandemic savings and stimulus checks, they’re still spending.

The robustness of the labor market has many observers baffled. Using data on weekly initial claims for jobless insurance, a good but noisy indicator of hiring trends, it appears that layoffs are falling again. Initial claims seemed to have hit a bottom in the spring and started a steady rise (exactly what the Fed was hoping to engineer), but the latest data show they’re falling.

This keeps consumers spending. Aaron Clark, equity portfolio manager at GW&K Investment Management, speculates that companies are mindful of the difficulty they had rehiring people after the pandemic, and are trying harder to avoid layoffs than they would in a typical cycle:

“It was so hard to hire that if they’re viewing this as just the Fed fighting inflation, then I think they’ll hold on to their workers longer than they might otherwise have done in a normal recession… They don’t want to now lay them off and then a year from now be trying to hire them back. So I think companies might be just willing to eat margins more and hold onto their workers in a slowdown.”

Thus tighter monetary policy is not yet severing consumers from their jobs and their paychecks. Beyond this, the Fed is also hoping to create a “wealth effect” to bring inflation down — falls in asset prices will make people feel poorer and less likely to spend. But even the deepening bear market won’t derail any consumption in the next several quarters, according to Doug Peta, chief US investment strategist at BCA Research. Americans, he said, will spend enough to keep the economy afloat:

“Empirically, changes in equity wealth have exerted little to no impact on consumption… Neither the equity bear market nor a softening housing market will stifle consumption. The Fed’s anti-inflation campaign will eventually induce a recession, but wealth effect concerns are overblown.”

Consumer spending has been on a near-perfect linear trend, barring the minor dip during the height of the pandemic in 2020, and an even shallower one during the Great Financial Crisis.

The mountain of excess savings US consumers accumulated across 2020 and 2021 have provided the foundation for their spending power. The wealth effect is real, Peta underscored, and household spending fluctuates depending on their current wealth. But the savings rate is low and declining, suggesting they are finding ways to keep spending.

What has a greater impact is changes in housing wealth, Peta said, citing a study by group of academics led by Yale University Nobel economics laureate Robert Shiller that analyzes the relationship between the consumer and home prices:

“Changes in equity wealth exert considerably less influence over changes in consumption than changes in housing wealth. With a two-quarter lag, year-over-year consumption has changed by nearly three cents for every dollar move in equity wealth… The housing wealth regression indicates that every dollar of changes in housing wealth leads to a 38-cent change in consumption.”

That housing wealth exerts a greater influence over equity wealth isn’t all that surprising, he said. Consider the geography. Nearly two-thirds of US households own their home — not to mention their homes being the largest asset for most people except perhaps wealthy families — while stock ownership is highly concentrated to a few. In fact, Peta pointed out that 50% of equities are owned by the top 1% of households by wealth.

Multiple data point to the resiliency of households, from credit card spending to consumer confidence, yet Luca Paolini, chief strategist at Pictet Asset Management, warns this may wear thin and that betting on endless consumer spending is “a very dangerous way of thinking”:

“Inflation is rising more than incomes, and the savings that consumers accumulated during COVID are still high but declining. The outlook of the consumer is better than the outlook for businesses… but I think we shouldn’t overestimate the fact that the labor market is the last thing to drop. In every recession, the labor market is strong before it gets worse.”

Nobody should extrapolate a strong US consumer long into the future, then. But the evidence is that consumer strength can last longer than anticipated. That’s good news for many, but also means at the margin that the Fed may need to keep rates higher for longer than it wanted.

I probably shouldn’t go there. But. Plenty of people are trying to argue that the gilt market implosion wasn’t caused by last Friday the day’s disastrously misjudged “mini-budget,” but by Federal Reserve and global rising bond yields. There is a grain of truth to this, in that the gilt meltdown required underlying conditions of rising rates and elevated risk aversion. But it’s still absurd to say that the new chancellor of the exchequer’s decision to announce the second-biggest tax cut in UK history, with no information on spending cuts to pay for it, wasn’t the trigger for the implosion, because it was.

International conditions were and remain difficult, and it was obvious to anyone that bond markets were likely to revolt if the UK tried to embark on a new wave of borrowing. That makes the bizarre decision to press ahead more, not less, culpable.

It’s best illustrated with an analogy made 12 years ago by the great bond investor Bill Gross, the founder of Pimco. He said: “The UK is a must to avoid. Its gilts are resting on a bed of nitroglycerine.” That call was a tad early, but we can use the illustration. When Kwasi Kwarteng arrived at the Treasury, the gilts market was indeed resting on nitroglycerine. Inflation and rising rates meant there was every danger that it would explode. And he could see this clearly. Yet his first move was to light a match and blow it up. As the global market was so evidently troubled, his decision to press ahead is unforgivable. He didn’t put the explosive there, but it was his decision to light the fuse.

Consider the spread of the UK bank rate over the fed funds rate over the last 12 months, as well as the spread of 10-year gilt yields over Treasuries. The Bank of England, hobbled by a more obviously troubled economy, slipped behind the Fed in the hiking cycle. Meanwhile, 10-year gilts continued to trade at a lower yield than Treasuries — until the morning of the mini-budget, when they overtook Treasuries in spectacular fashion.

It’s also inaccurate to say: “No, the pound isn’t crashing over a trifling batch of tax cuts. It’s because the markets are terrified of Starmer.” That was the headline on an article by Conservative peer Daniel Hannan published by the website. Keir Starmer is the leader of the opposition Labor party, whose chances of coming to power in 2024 seem to have improved this week. Markets would doubtless prefer Britain not to move back to the center-left. Political uncertainty was a component in the loss of confidence. But the greatest problem was the appearance that the current government is incompetent, and that yet another leadership change lies ahead. In a week dominated by discussions of the gilt markets, I hadn’t seen or heard Starmer’s name mentioned even once until that article. The next general election is two years away, far too distant for markets to pay attention to Labor’s improvement in the polls.

When criticizing a politician, it’s difficult to avoid the appearance of making a political point. But the facts in this case are obvious. This was one of the biggest and most damaging market reactions to a policy announcement in memory. The error was entirely avoidable and self-inflicted, and its perpetrators have no choice but to own it.